Chapter 08 - Inventories and The Cost of Goods Sold

8 INVENTORIES AND THE COST OF GOODS SOLD

Chapter Summary
The chapter is a detailed introduction to the cost flow assumptions used to value inventories and measure the cost of goods sold. Application of specific identification, average cost, I ! and "I ! is first e#amined within the conte#t of a perpetual inventor$ s$stem. The impact of the flow assumption emplo$ed on income ta#es is discussed in detail. The need for a ph$sical inventor$ to assess inventor$ shrin%age is also reviewed as are the accounting procedures necessar$ to record inventor$ shrin%age. A &rief presentation of lower-of-costor-mar%et write downs concludes the discussion of perpetual s$stems. Application of the flow assumptions within a periodic s$stem is ne#t e#plained. 'e also demonstrate that restatement of ending inventor$ &$ the periodic method results in the ma#imum ta# advantage from the "I ! flow assumption. The chapter covers a num&er of additional issues surrounding inventor$ accounting. These include( the financial statement effects of inventor$ errors) the retail and gross profit methods for estimating ending inventor$) and, an anal$sis of the inventor$ turnover ratio.

Learning Objectives
1. In a perp e t u a l invent or $ s$st e m, det er mi n e the cost of goods sold using *a+ sp e c i f i c ide n t i f i c a t i o n , *&+ av e r a g e co s t , *c+ FIFO , and *d+ LIFO . ,iscus s the adva n t a g e s and shortc o mi n g s of eac h me t h o d. 2. 3. -#plain the nee d for ta%ing a ph$sic al invent or $. .ecord shri nk a g e los s e s and other $ear- end ad/us t m e n t s to invent or $.

4. In a periodic invent or $ s$st e m, det er mi n e the ending invent or $ and the cost of goods sold using *a+ sp e c i f i c ide n t i f i c a t i o n , *&+ av e r a g e co s t , *c+ FIFO , and *d+ LIFO . 5. -#plain the effects on the income stat e m e n t of errors in invent or $ valua tion.

6. -stima t e the cost of goods sold and ending invent or $ &$ gr o s s profi t me t h o d and the ret ail met h o d . 7. Comp ut e the inv e n t o r t!rn o v e r and e#plain its use s.

Brief topical outline

" The flow of inventor$ costs 1 'hich unit did we sell0 2 ,ata for an illustration 3 Specific identification 4 Cost flow assumptions 5 Average-cost method

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Chapter 08 - Inventories and The Cost of Goods Sold

6 7 #

'

irst-in, first-out method "ast-in, first-out method -valuation of the methods a Specific identification $ Average cost c irst-in, first-out d "ast-in, first-out % ,o inventor$ methods reall$ affect performance0 1& The principle of consistenc$ 11 2ust-in-time *2IT+ inventor$ s$stem - see Case in Point *page 34#+ Ta%ing a ph$sical inventor$ 1 .ecording shrin%age losses 2 "C3 and other write-downs of inventor$ a The lower-of-cost-or-mar%et *"C3+ rule 3 The $ear-end cutoff of transactions a 3atching revenue and the cost of goods sold $ Goods in transit - see Your Turn *page 351+ 4 4eriodic inventor$ s$stems a Appl$ing flow assumption in a periodic s$stem $ Specific identification c Average cost d I ! e "I ! - see Case in Point *page 353+ f .eceiving the ma#imum ta# &enefit from the "I ! method g 4ricing the $ear-end inventor$ &$ computer 5 International inancial .eporting Standards 6 Importance of an accurate valuation of inventor$ a -ffects of an error in valuing ending inventor$ $ Inventor$ errors affect two $ears c -ffects of errors in inventor$ valuation( a summar$ 7 Techni5ues for estimating the cost of goods sold and the ending inventor$ # The gross profit method % The retail method 1& Te#t&oo% inventor$ s$stems can &e modified6and the$ often are inancial anal$sis and decision ma%ing 1 Inventor$ turnover - see Your Turn *page 35%+ 2 .eceiva&les turnover 3 "ength of the operating c$cle 4 Accounting methods can affect financial ratios - see Ethics, Fraud & Corporate Governance *page 35%+ Concluding remar%s

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Chapter 08 - Inventories and The Cost of Goods Sold

Topical coverage and suggested assignment

*ome+ork "ssignment ,-o 'e (ompleted .rior to (lass/ (lass 0eetings on (hapter 1 7 8 -opical O!tline (overage A 9 C-, )isc!ssion 1!estions 1, 7, 8 :, ;, <, 10 1: 'rief 23ercises 1, 8 :, ; 10 23ercises 7, 8 ;, <, 10 17, 18, 1> .ro$lems 7, 8 :, =, ; (ritical -hinking (ases 1 8

Comments and observations -eaching o$4ectives for (hapter # !ur specific teaching o&/ectives in this chapter are to( 1 -#plain wh$ it is necessar$ for a compan$ with an inventor$ to either use specific identification or adopt a ?flow assumption.? 2 3 4 5 6 7 # Illustrate the ?flow of costs? into the cost of goods sold account using each costing method *specific identification, average cost, I !, and "I !+. ,iscuss the factors to &e considered in the selection of an appropriate cost method. Illustrate the recording of shrin%age losses and other $ear-end ad/ustments to inventor$ *e#cepting that in o&/ective =, &elow+. Illustrate the valuation of ending inventor$ using periodic costing procedures. -#plain wh$ companies using perpetual "I ! might ad/ust the valuation of inventor$ at $ear-end to the amount indicated &$ periodic "I ! costing procedures. Illustrate the gross profit and retail methods of estimating the cost of goods sold and ending inventor$. ,iscuss the purpose of computing a compan$@s inventor$ turnover rate.

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Chapter 08 - Inventories and The Cost of Goods Sold

General comments As in the previous edition, we emphasiAe the perpetual inventor$ s$stem primaril$ &ecause this is the method now in predominant use. Teaching with an emphasis on perpetual inventor$ s$stems has a num&er of &enefits in the classroom. !f greatest importance, a perpetual s$stem shifts the focal point of cost assignment from ending inventor$ to the cost of goods sold. As a result, the names of the flow assumptions finall$ ?mean what the$ sa$.? or e#ample, ?first-in, first-out? means that the first costs are used in the cost assignment process) ?last-in, first-out? means that the last costs are used. Bnder a periodic s$stem, the reverse is true. *-#perienced instructors will remem&er tr$ing to e#plain to students that ?first-in, first-out? actuall$ means that the latest costs are assigned to inventor$, whereas ?last-in, first-out? reall$ means the first costs are assigned.+ Cot onl$ do students more 5uic%l$ grasp the concepts underl$ing the flow assumptions when we assume a perpetual inventor$ s$stem, &ut the$ also 5uic%l$ grasp the effects of using different assumptions during a period of rising prices. This ena&les us to emphasiAe the effects of different methods upon earnings, income ta# considerations, and even the implications of "I ! reserves. 'e use -#ercise 2 to illustrate the &asic cost-flow assumptions and follow it with a discussion of -#ercise 11 to demonstrate the effects of using alternative methods. -#ercise 12 presents a more challenging anal$sis of the same points. 'e also discuss in class such topics as ?/ust-in-time? s$stems, inventor$ shrin%age, and the factors management should consider in determining the optimal siAe of a compan$@s inventor$. These discussions portra$ inventor$ as ph$sical goods moving in and out of the &usiness, rather than merel$ as a dollar amount. 'e find that these discussions contri&ute to students@ interest, and also to their understanding of the importance of inventories to accountants, managers, and investors. Supplemental Exercises Business Week Exercises D.etailers vs. 9u$ers( 'ho 'ill 9lin% irst0E, Business Week, ,ecem&er 1:, 7008, discusses the conse5uences of retailers %eeping stoc%s low for the 7008 Fuletide season, while consumers are awaiting sales. -#plain how e#cessive inventories can hurt a retailerGs &ottom line. Group Exercise !ne of the most spectacular financial frauds of the 1<80Gs involved computer peripherals manufacturer 3iniscri&e, Inc. .esearch the fraud and report on how inventor$ accounting &$ 3iniscri&e contri&uted to the production of grossl$ misleading financial statements. Hint( A good place to &egin $our research will &e the Inde# of the Wall Street Journal. nternet Exercise Iisit 'al3artGs we&sit e at htt p56 6 + + + . + a l m a r t . c o m 6 and acce s s their mos t rec e n t annu al report. "ocat e the su m m a r $ of significa nt accoun tin g policies and find the invent or $ me t h o d* s + use d &$ 'al3art.

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Chapter 08 - Inventories and The Cost of Goods Sold

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Indicate the &est answer for each 5uestion in the space provided. 1 The primar$ purpos e of an inventor$ flow assu mp tion is to( a Increas e inventor$ turnover. $ Increas e gross profit. c ,eter min e which unit costs are assigne d to inventor$ and which are assigne d to the cost of goods sold. d 3inimiAe ta#a&le income during periods of rising prices. ,uring a period of stea dil$ rising prices, which of the following inventor$ valuation met hod s is li%el$ to result in the lowest cost of goods sold 0 a "I !. $ I !. c The retail method. d The gross profit met hod. primar$ reason for the popularit$ of the "I ! flow assu mp tion is this method( Is most appropriat e when each item in inventor$ is uni5ue. Tends to minimiAe ta#a&le income . Cause s inventor$ to &e report e d at or near its current .educ e s the amount of mone $ Dtied upE in inventor$.

The that a $ c replace m e n t cost. d 4

In a periodic inventor$ s$st e m, the cost of goods sold is deter min e d &$( a 3ultipl$ing net sales for the period &$ a cost ratio. $ 2ournal entries mad e at the time of each sales trans a ction. c 4h$sicall$ counting the 5uantities of mercha n dis e sold each da$, and deter mining the cost of thes e items at $ear- end. d Su&tracting the cost assigne d to the ending inventor$ from the cost of goods availa&le for sale during the period. Salerno Co. has an inventor$ turnover rate of ; and an account s receiva &le turnover rate of :. Assuming 8=: da$s in a $ear, the period of time re5uired for Salerno to convert its inventor$ into cash through normal &usines s operations is appro#ima t el$( a 71 da$s. $ :7 da$s. c > months. d 7.: mont hs.

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Chapter 08 - Inventories and The Cost of Goods Sold

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Ace S$ste ms , Inc. uses a perpet u al inventor$ s$st e m. The compa n $Gs &eginning inventor$ of a particular product and its purcha s e s during the mont h of 2anuar$ were as follows( 1!an t i t (os t 9eginning inventor$ *2an. 1+ .................. 4urcha s e *2an. 1:+ ..................................... 4urcha s e *2an. 78+ ..................................... Total ......................................................... 10 1: : 80 J7;.:0 J78.00 J7<.00 J7;: J>70 J1>: J8>0 ;nit (ost -otal

!n 2anuar$ 78, Ace S$ste ms sells 18 units of this product. The other 17 units remain in inventor$ at 2anuar$ 81. 1 Ref e r to ab o v e da t a . Assuming that Ace S$ste ms uses the avera g e cost flow assu mp tion, the cost of goods sold to &e recorde d at 2anuar$ 78 is( a J:0>. c J><<. $ J88=. d Some other amount. Ref e r to ab o v e da t a . Assuming that Ace S$ste ms uses the "I ! flow assu mp tion, the cost of goods sold on 2anuar$ 78 is( a J881. c J><<. $ J:0<. d Some other amount. Ref e r to ab o v e da t a . Assuming that Ace S$ste ms uses the assu mp tion, the cost of goods sold on 2anuar$ 78 is( a J:0<. c J><<. $ J8>1. d Some other amount. Ref e r to ab o v e da t a . Assuming assu mp tion, the 17 units of this have a total cost of( a J><<. c $ J881. d Ref e r to ab o v e da t a . Assuming assu mp tion, the 17 units of this have a total cost of( a J8>1 c $ J:0<. d I ! flow

that Ace S$ste ms uses the "I ! flow product in inventor$ at 2anuar$ 81 J:0<. Some other amount. that Ace S$ste ms uses the I ! flow product in inventor$ at 2anuar$ 81 J><<. Some other amount.

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Chapter 08 - Inventories and The Cost of Goods Sold

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Canfield uses a perpet u al inventor$ s$st e m. The compa n $Gs &eginning inventor$ of a particular product and its purcha s e s during the mont h of 2anuar$ were as follows( 1!an t i t -otal (os t 9eginning inventor$ *2an. 1+ ...................................... 4urcha s e *2an. 10+ ......................................................... 4urcha s e *2an. 77+ ......................................................... Total ......................................................................... :0 7: 7: 100 J= J; J8 ;nit (ost

J800 J1;: J700 J=;:

!n 2anuar$ 7:, Canfield sells :: units of this product. inventor$ at 2anuar$ 81. a

The other >: units remain in

,eter min e the cost of goods sold using each of the following flow assu mp tions( *1+ "I ! *7+ I ! JKKKKKKKKKKKKK JKKKKKKKKKKKKK JKKKKKKKKKKKKK

*8+ Average cost $

,eter min e the cost of the >: units in inventor$ at 2anuar$ 81 using each of the following flow assu mp tions( *1+ "I ! *7+ I ! JKKKKKKKKKKKKK JKKKKKKKKKKKKK JKKKKKKKKKKKKK

*8+ Average cost

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Chapter 08 - Inventories and The Cost of Goods Sold

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Sher ma n -lectric uses a periodic inventor$ s$ste m. The &eginning inventor$ of a particular product, and the purcha s e s during the current $ear, were as follows( 2an. 1 9eginning inventor$ ..................... 3ar. 8 4urcha s e ........................................... Aug. 11 4urcha s e ........................................... !ct. 78 4urcha s e .......................................... Total availa&le for sale ................................ =0 80 <0 70 700 units units units units units L L L L J10: J11: J17: J18: M J =,800 M 8,>:0 M 11,7:0 M 7,;00 J78,;00

At ,ece m& e r 81, the ending inventor$ of this product consist e d of =: units. Bsing periodic costing proce dur e s , deter min e *1+ cost of the $ear- end inventor$ and, *7+ cost of goods sold relating to this product under each of the following flow assu mp tions( ,1/ Inve n t o r >ood s =old a $ c Average cost irst -in, first -out "ast -in, first -out JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK JKKKKKKKKKKKKKKK ,2/ (ost of at )ec. 31

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Chapter 08 - Inventories and The Cost of Goods Sold

=OL;-IO8= -O (*".-27 # 1;I< " 1 2 3 4 5 C 9 9 , C 1;I< ' 1 2 3 4 5 A 9 C 9 A

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"earning !&/ective( 1, >, ; 1;I< ( a

"earning !&/ective( 1

Cost of goods sold *1+ J>0: *7: L J8+ N *7: L J;+ N *: L J=+ *7+ J88: *:0 L J=+ N *: L J;+ *8+ J8;1.7: *=;: O 100+ # :: Inventor$ at 2an. 81( *1+ J7;0 *J=;: - J>0:+ *7+ J8>0 *J=;: - J88:+ *8+ J808.;: *>: L J=.;:+

"earning !&/ective( 1 1;I< ) a Average cost( Inventor$ J;,;07.:0 P=: L *J78,;00 700+Q Cost of goods sold J1:,<<;. :0 *J78,;00 - J;,;07.:0+ irst- in, first- out( Inventor$ J8,87: *70 L J18: N >: L J17:+ Cost of goods sold J1:,8;: *J78,;00 - J8,87:+ "ast- in, first- out( Inventor$ J=,8;: *=0 L 10: N: L 11:+ Cost of goods sold J1=,87: *J78,;00 - J=,87:+ "earning !&/ective( >

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Chapter 08 - Inventories and The Cost of Goods Sold

Assignment Guide to Ch !te" 8

'rief 23erci s e s 1 R 10 -ime e s ti m a t e ,in min ! t e s / )iffic !l t ratin g Learni n g O$4e c ti v e s 5 1. In a p erp e t ! a l inv e n t o r s s t e m ? de t e r m i n e th e co s t of go o d s sol d !si n g ,a/ sp e c i f i c id e n ti fi c a t i o n ? ,$/ av e r a g e co s t ? ,c/ FIFO? an d ,d/ LIFO. )is c ! s s th e ad v a n t a g e s an d sh o r t c o m i n g s of ea c h me t h o d . 2. 23plai n th e ne e d for taki n g a ph si c a l inv e n t o r . 3. 7ec o r d shri n k a g e los s e s an d ot h e r e ar: en d ad4! s t m e n t s to inv e n t o r . 4. In a p eri o d i c inv e n t o r s s t e m ? de t e r m i n e th e en d i n g inv e n t o r an d th e co s t of go o d s sol d !si n g ,a/ sp e c i f i c id e n ti fi c a t i o n ,$/ av er a g e co s t ? ,c/ FIFO? an d ,d/ LIFO. 5. 23plai n th e eff e c t s on th e inc o m e st a t e m e n t of error s in inv e n t o r val! a t i o n . 6. 2sti m a t e th e co s t of go o d s sol d an d en d i n g inv e n t o r $ th e gro s s profi t me t h o d an d $ th e ret ail m e t h o d . 7. (om p ! t e th e inv e n t o r t!rn o v e r rat e an d e3 p l ai n its !s e s . S 10 1, 7 23erci s e s 1- 1: <1: 1 > 0 3 7 >0 3 8 7 : S > 80 3 .ro$ l e m s : =0 S = 7: ; 7: 3 8 8 : 3 1 7: 3 (as e s 7 80 3 8 80 3 8et > >0 -

1, 7, 11, 17

1, : = 1,=

1, 7, 8, >, : ;, 8

1, 8, >, ; 1, 8

<, 10

1, <, 10 1, 11, 17, 18, 1>, 1:

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